Tuesday, May 12, 2009

The First Crack in the Fed's Armor

The WSJ is reporting that former NY Fed President and now U.S. Treasury Secretary Timothy Geithner admitted that the loose monetary policy of the Fed and other central bankers in the early-to-mid 2000s contributed to the economic imbalances that led to this current economic crisis:

I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful...It was too easy, yes. In some ways less so here in the United States, but it was true globally. Real interest rates were very low for a long period of time.

For all the grief the Treasury Secretary is receiving, he should be given credit for this admission of policy failure. I would note, though, that monetary policy was highly expansionary across the globe primarily because it was expansionary in the United States. As I have noted earlier:

The Fed is a is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. (See this post on evidence for U.S. monetary policy being exported to ECB.) The global liquidity glut story seems most compelling for the 2002-2004 period when the Fed's policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate). Thus, its highly accommodative monetary policy during this time was exported to the world.

I am hoping the Secretary's admission will open the door for a meaculpa from those Fed officials who actually oversaw U.S. monetary policy at this time. If we are to learn from this experience we need to come clean on all the contributors to this economic crisis.